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Fed worries about spillover from Europe's debt crisis to U.S. financial system

June 22, 2011 | 8:59
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So let’s say Greece or one of the other financially weakest countries in Europe were to default on its bonds. Would that hit the U.S. banking system?

Federal Reserve Chairman Ben S. Bernanke was asked that question at his news conference on Wednesday. The response he gave was pretty much what many on Wall Street already had assumed: U.S. banks don’t have much in the way of direct financial holdings in Greece and Europe’s other “peripheral” countries (Ireland, Portugal).

Still, the Fed worries that the indirect effects of a European debt blow-up could be “quite significant” in U.S. markets, Bernanke conceded.

He also singled out U.S. money market mutual funds, which make very short-term loans to banks and other institutions, as an area of “concern” in terms of European investments.

Given that the European government-debt crisis began to unfold in November 2009, U.S. banks have had plenty of time to get out of the riskiest securities. Greece got its first bailout from the rest of the euro-zone countries a year ago. Ireland was bailed out last fall and Portugal followed spring.

Europe’s financial system has been rocked in recent months by fears that Greece was headed for default despite its year-old bailout. The Greeks now want another chunk of money from the rest of Europe to avoid default on nearly $500 billion in government debt. The Athens government, which has agreed to a new round of harsh austerity measures in return for the second bailout, met a critical test on Tuesday when it survived a no-confidence vote by the Greek Parliament.

Next up: Parliament must approve the austerity package by the July 3 deadline set by euro-zone authorities.

By now, it would be hard to imagine any U.S. bank having much at stake in Greece, Portugal or Ireland. But U.S. banks’ finances are intertwined with those of the largest European banks in Germany, France and Britain, the “non-peripheral” countries. And many of those European giants naturally have plenty at stake in their poorer neighbors via loans or bond holdings.

Here’s how Bernanke put it:

We have been very assiduous in examining the exposures of financial institutions to the so-called peripheral countries. The answer is that the banks that we regulate are not significantly exposed to those countries directly, at least.

They have significant exposures to European banks in the non-peripheral countries, and so indirectly they have that exposure. And that statement which I just made includes credit default swaps and so on.

With regard to Greece, specifically, Bernanke said the Fed has “asked the banks to, essentially, do stress tests and ask, looking at all their positions, all the hedges, what would the effect on their capital be if Greece defaulted. And the answer is that the effects are very small.”

But later in the same answer, Bernanke warned of potentially broader effects that regulators can’t predict:

A disorderly default in one of those countries would no doubt roil financial markets globally, would have a big impact on credit spreads, on stock prices and so on. And so in that respect, I think the effects on the United States would be quite significant.

Bernanke also said the Fed was keeping a “close eye” on the $2.7-trillion money market mutual fund industry, even though the central bank doesn’t regulate the funds.

"There again, the situation is similar in some sense [to banks’ situation], in that, with very few exceptions, the money market mutual funds don’t have much direct exposure to the three peripheral countries which are currently dealing with debt problems," Bernanke said. "They do have very substantial exposure to European banks in the so-called core countries: Germany, France, etc.

"So to the extent that there is indirect impact on the core European banks, that does pose some concern to money market mutual funds," he said.

Fitch Ratings said in a report this week that the biggest U.S. money funds have about 50% of their assets in debt or certificates of deposit of European banks, mainly large British, German and French institutions.

But the Investment Company Institute, the funds’ trade group, sought to downplay worries about money funds' holdings in a brief report it issued early this week.